For nearly a decade, rate caps and swaps were at best deemed a necessary insurance policy against rate hikes, and at worst, an unnecessary expense that served no purpose in a stable market. Today, these hedging techniques have reemerged as crucial elements to variable interest rate financing.
After emerging from the financial crisis of 2008, borrowers enjoyed nearly a decade of suppressed interest rates.
With the onset of the COVID-19 pandemic, rates were pushed down even further as a stimulus to the post- lockdown economy.
As the interest rate environment remained stable — and even declining — resulting in a robust commercial real estate market, it also led to a vicious inflation cycle. The Federal Reserve has since pledged to tame the inflation in an expedient manner, through a rapid and drastic increase in interest rates over roughly the last 12 months.
This swift increase in interest rates triggered high market volatility; so, while for years variable rate loans were only that in name — as rates were incredibly stable — their associated hedging transactions, including caps and swaps, were inexpensive techniques to act as belt and suspenders to protect against volatility that ultimately never arose.
Today, variable rate loans, the once advantageous borrowing method utilized extensively prior to the Fed rate hikes and subsequent rate volatility, have been severely impacted, and the hedging mechanisms once thought to be mere window dressing are now the difference between borrowers remaining current on their obligations and defaulting due to the sharply increasing debt service requirements of their variable rate loans.
A variable interest rate loan has an interest rate on the outstanding balance that rises or falls based on the current status of the market interest rate. Leading up to the recent spike in interest rates, many borrowers were opting to finance their acquisitions and refinancings with floating, or variable rate, debt.
In a market where rates are stable or potentially declining — the type of market that borrowers enjoyed for an extended period of time — variable rate debt can be advantageous. But in an unstable market subject to rate spikes, a property financed with variable rate debt, which may have been performing quite well in a stable rate environment, can quickly become cash-strapped and result in defaults due to rate increases and a corresponding jump in the borrower’s monthly interest payment.
To hedge against volatile market conditions, or even just a nominal rising interest rate environment, two main techniques are typically utilized: interest rate caps and interest rate swaps.
Interest rate caps allow borrowers to set an upper limit on the interest rates for a variable rate loan. A rate cap essentially serves as an insurance policy for both the borrower and lender against rate increases by locking in a maximum interest rate. While borrowers are subject to paying an upfront fee to the rate cap provider, in a volatile market, that money is well spent.
A rate cap is a derivative product in which the cap provider agrees to pay to the borrower — the buyer of the cap
— an amount equal to the principal balance of the loan multiplied by the difference between the actual variable rate that is payable pursuant to the loan documents and a set strike rate.
For instance, if the principal balance of the loan is $100, the strike rate is 3% and the variable rate for a particular month is 4%, the rate cap provider would pay to the owner of the rate cap $1, which is equal to 4% (the actual Shmuel Goldis rate) less 3% (the strike rate) multiplied by $100.
The third-party cap provider, in exchange for the premium, guarantees that the borrower will never have to pay interest on a rate in excess of 3%, thus protecting both borrowers and lenders from a rise in rates.
This also allows banks to feel confident that the debt payments will not be missed due to an unstable rate environment, and provides the borrower peace of mind knowing that it will not have to worry about paying exorbitant interest payments even if interest rates increase[1].
While the lender does not make any money off the purchase or the implementation of the cap, lenders want a cap to be in place on a variable rate loan to ensure that the borrower does not find itself in a position where, as a result of a rate increase, the borrower’s cash flow is insufficient to make its monthly interest payments. Lenders are thereby reassured that borrowers will be able to meet their debt payments if and when interest rates rise.
Borrowers see caps at their most basic — as an upfront insurance policy to protect against a volatile interest rate environment.
Nowadays, with a tightening Fed and elevated interest rates, interest rate caps are, in theory, excellent options to hedge debt positions.
However, the lower the demanded strike price, the higher the premium. Moreover, as market volatility — or the projection of volatility — increases, cap providers typically will, and in today’s current market have, increased their premium rates in concert with the market to accommodate the increased risk to the cap provider. That said, it is often the price of admission for a borrower that needs or wishes to obtain variable rate debt.
In order to bring down upfront cap purchase costs, some lenders have structured their loans with a so-called springing rate cap. A springing rate cap, as defined by Chatham Financial, “requires a borrower to purchase an interest rate cap post loan closing if (and only if) the base rate for a floating-rate loan (i.e. SOFR) crosses a certain threshold.”[2]
This allows the borrower to defer the purchase of a rate cap, and potentially avoid it altogether, if rates do not exceed the threshold triggering the purchase.
While borrowers generally prefer a springing cap concept, the concern with springing rate caps — a concern that has arisen repeatedly in current practice — is that by the time the rate cap purchase is triggered, the cost to purchase the cap has become prohibitively expensive.
While this scenario could be the subject of an article in and of itself, the result is often that the lender and borrower end up back at the table to discuss revised terms of the required rate cap in an effort to achieve a solution that cures for both the cost of the cap and the necessary protection it provides.
Borrowers and lenders seeking hedging solutions may also consider interest rate swaps. A swap, in the context of a commercial real estate loan, and in its simplest form, is a derivative contract whereby the borrower exchanges (with a counterparty) its obligation to make variable rate payments for the obligation to make fixed-rate payments.
For instance, Party A has a loan with a variable rate, and Party B — the swap provider — agrees to pay on Party A’s behalf the monthly interest due on Party A’s loan at the variable rate. Party A agrees to pay to Party B an amount equal to the agreed upon, as between
Party A and Party B, fixed rate multiplied by the principal amount of Party A’s loan. Neither party, though, actually takes ownership of the other party’s debts or assets.
Swaps pose benefits and risks for each party involved in the transaction. The party that is receiving the fixed-rate payment profits if interest rates fall and loses if interest rates rise.
Conversely, the party that is paying the fixed-rate payment profits if rates rise and loses if rates fall. In either scenario, the borrower locks in a maximum — and consistent — monthly payment. Note, however, that there is also an inherent counterparty and credit risk with regard to swaps, as there is the possibility that the counterparty to the transaction is unable to make the payments required.
While both interest rate caps and interest rate swaps allow borrowers and lenders to hedge against potential losses associated with variable rate loans, they are wholly different products in terms of cost and execution.
Caps require an upfront payment in exchange for an “insurance policy” that a borrower may never benefit from (assuming rates are stable or declining), whereby swaps, which have no upfront costs, are far more speculative and may result in a net loss — at least on paper — to the borrower if rates fall.
As always, it is prudent to understand the different categories and styles of hedging techniques, and for lenders and borrowers to choose the most cost-effective and financially prudent hedge product for their particular loan.
Richard Favata and William McConnell are partners, and Shmuel Goldis is an associate, at Cassin & Cassin LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Weinstock, E. (2017, June 15) How to Use Rate Caps to Protect Against Interest-Rate Hikes. Available at:
https://www.multifamilyexecutive.com/business-finance/how-to-use-rate-caps-to-protect-against-interest-rate-hikes_o.
[2] Moore, C., & Church, A (n.d.). “Springing” Interest Rate Cap Requirements in CRE Loans.
https://www.chathamfinancial.com/insights/springing-interest-rate-cap-requirements-in-cre-loans.
Hedging Variable Interest Rates In A Volatile Market, Law 360
For nearly a decade, rate caps and swaps were at best deemed a necessary insurance policy against rate hikes, and at worst, an unnecessary expense that served no purpose in a stable market. Today, these hedging techniques have reemerged as crucial elements to variable interest rate financing.
After emerging from the financial crisis of 2008, borrowers enjoyed nearly a decade of suppressed interest rates.
With the onset of the COVID-19 pandemic, rates were pushed down even further as a stimulus to the post- lockdown economy.
As the interest rate environment remained stable — and even declining — resulting in a robust commercial real estate market, it also led to a vicious inflation cycle. The Federal Reserve has since pledged to tame the inflation in an expedient manner, through a rapid and drastic increase in interest rates over roughly the last 12 months.
This swift increase in interest rates triggered high market volatility; so, while for years variable rate loans were only that in name — as rates were incredibly stable — their associated hedging transactions, including caps and swaps, were inexpensive techniques to act as belt and suspenders to protect against volatility that ultimately never arose.
Today, variable rate loans, the once advantageous borrowing method utilized extensively prior to the Fed rate hikes and subsequent rate volatility, have been severely impacted, and the hedging mechanisms once thought to be mere window dressing are now the difference between borrowers remaining current on their obligations and defaulting due to the sharply increasing debt service requirements of their variable rate loans.
A variable interest rate loan has an interest rate on the outstanding balance that rises or falls based on the current status of the market interest rate. Leading up to the recent spike in interest rates, many borrowers were opting to finance their acquisitions and refinancings with floating, or variable rate, debt.
In a market where rates are stable or potentially declining — the type of market that borrowers enjoyed for an extended period of time — variable rate debt can be advantageous. But in an unstable market subject to rate spikes, a property financed with variable rate debt, which may have been performing quite well in a stable rate environment, can quickly become cash-strapped and result in defaults due to rate increases and a corresponding jump in the borrower’s monthly interest payment.
To hedge against volatile market conditions, or even just a nominal rising interest rate environment, two main techniques are typically utilized: interest rate caps and interest rate swaps.
Interest rate caps allow borrowers to set an upper limit on the interest rates for a variable rate loan. A rate cap essentially serves as an insurance policy for both the borrower and lender against rate increases by locking in a maximum interest rate. While borrowers are subject to paying an upfront fee to the rate cap provider, in a volatile market, that money is well spent.
A rate cap is a derivative product in which the cap provider agrees to pay to the borrower — the buyer of the cap
— an amount equal to the principal balance of the loan multiplied by the difference between the actual variable rate that is payable pursuant to the loan documents and a set strike rate.
For instance, if the principal balance of the loan is $100, the strike rate is 3% and the variable rate for a particular month is 4%, the rate cap provider would pay to the owner of the rate cap $1, which is equal to 4% (the actual Shmuel Goldis rate) less 3% (the strike rate) multiplied by $100.
The third-party cap provider, in exchange for the premium, guarantees that the borrower will never have to pay interest on a rate in excess of 3%, thus protecting both borrowers and lenders from a rise in rates.
This also allows banks to feel confident that the debt payments will not be missed due to an unstable rate environment, and provides the borrower peace of mind knowing that it will not have to worry about paying exorbitant interest payments even if interest rates increase[1].
While the lender does not make any money off the purchase or the implementation of the cap, lenders want a cap to be in place on a variable rate loan to ensure that the borrower does not find itself in a position where, as a result of a rate increase, the borrower’s cash flow is insufficient to make its monthly interest payments. Lenders are thereby reassured that borrowers will be able to meet their debt payments if and when interest rates rise.
Borrowers see caps at their most basic — as an upfront insurance policy to protect against a volatile interest rate environment.
Nowadays, with a tightening Fed and elevated interest rates, interest rate caps are, in theory, excellent options to hedge debt positions.
However, the lower the demanded strike price, the higher the premium. Moreover, as market volatility — or the projection of volatility — increases, cap providers typically will, and in today’s current market have, increased their premium rates in concert with the market to accommodate the increased risk to the cap provider. That said, it is often the price of admission for a borrower that needs or wishes to obtain variable rate debt.
In order to bring down upfront cap purchase costs, some lenders have structured their loans with a so-called springing rate cap. A springing rate cap, as defined by Chatham Financial, “requires a borrower to purchase an interest rate cap post loan closing if (and only if) the base rate for a floating-rate loan (i.e. SOFR) crosses a certain threshold.”[2]
This allows the borrower to defer the purchase of a rate cap, and potentially avoid it altogether, if rates do not exceed the threshold triggering the purchase.
While borrowers generally prefer a springing cap concept, the concern with springing rate caps — a concern that has arisen repeatedly in current practice — is that by the time the rate cap purchase is triggered, the cost to purchase the cap has become prohibitively expensive.
While this scenario could be the subject of an article in and of itself, the result is often that the lender and borrower end up back at the table to discuss revised terms of the required rate cap in an effort to achieve a solution that cures for both the cost of the cap and the necessary protection it provides.
Borrowers and lenders seeking hedging solutions may also consider interest rate swaps. A swap, in the context of a commercial real estate loan, and in its simplest form, is a derivative contract whereby the borrower exchanges (with a counterparty) its obligation to make variable rate payments for the obligation to make fixed-rate payments.
For instance, Party A has a loan with a variable rate, and Party B — the swap provider — agrees to pay on Party A’s behalf the monthly interest due on Party A’s loan at the variable rate. Party A agrees to pay to Party B an amount equal to the agreed upon, as between
Party A and Party B, fixed rate multiplied by the principal amount of Party A’s loan. Neither party, though, actually takes ownership of the other party’s debts or assets.
Swaps pose benefits and risks for each party involved in the transaction. The party that is receiving the fixed-rate payment profits if interest rates fall and loses if interest rates rise.
Conversely, the party that is paying the fixed-rate payment profits if rates rise and loses if rates fall. In either scenario, the borrower locks in a maximum — and consistent — monthly payment. Note, however, that there is also an inherent counterparty and credit risk with regard to swaps, as there is the possibility that the counterparty to the transaction is unable to make the payments required.
While both interest rate caps and interest rate swaps allow borrowers and lenders to hedge against potential losses associated with variable rate loans, they are wholly different products in terms of cost and execution.
Caps require an upfront payment in exchange for an “insurance policy” that a borrower may never benefit from (assuming rates are stable or declining), whereby swaps, which have no upfront costs, are far more speculative and may result in a net loss — at least on paper — to the borrower if rates fall.
As always, it is prudent to understand the different categories and styles of hedging techniques, and for lenders and borrowers to choose the most cost-effective and financially prudent hedge product for their particular loan.
Richard Favata and William McConnell are partners, and Shmuel Goldis is an associate, at Cassin & Cassin LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Weinstock, E. (2017, June 15) How to Use Rate Caps to Protect Against Interest-Rate Hikes. Available at:
https://www.multifamilyexecutive.com/business-finance/how-to-use-rate-caps-to-protect-against-interest-rate-hikes_o.
[2] Moore, C., & Church, A (n.d.). “Springing” Interest Rate Cap Requirements in CRE Loans.
https://www.chathamfinancial.com/insights/springing-interest-rate-cap-requirements-in-cre-loans.
SHARE
CONTACT
Richard Favata
Partner
914.517.6962
rfavata@cassinllp.com